Covered interest parity arbitrage and temporal long-term dependence between the US dollar and the Yen

Jonathan A. Batten*, Peter G. Szilagyi

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

8 Citations (Scopus)

Abstract

Using a daily time series from 1983 to 2005 of currency prices in spot and forward USD/Yen markets and matching equivalent maturity short-term US and Japanese interest rates, we investigate the sensitivity of the difference between actual prices in forward markets to those calculated from differentials in short-term interest rates. According to a fundamental theorem in financial economics termed covered interest parity (CIP), the actual and estimated prices should be identical once transaction and other costs are accommodated. The paper presents three important findings: first, we find evidence of considerable variation in CIP deviations from equilibrium; second, these deviations have diminished significantly and by 2000 have been almost eliminated; third, an analysis of the CIP deviations using the local Hurst exponent finds episodes of time-varying dependence over the various sample periods, which appear to be linked to episodes of dollar decline/Yen appreciation, or vice versa. The finding of temporal long-term dependence in CIP deviations is consistent with recent evidence of temporal long-term dependence in the returns of currency, stock and commodity markets.

Original languageEnglish
Pages (from-to)409-421
Number of pages13
JournalPhysica A: Statistical Mechanics and its Applications
Volume376
Issue number1-2
DOIs
Publication statusPublished - 15 Mar 2007

Keywords

  • Arbitrage
  • Covered interest parity
  • Efficient market hypothesis
  • Hurst exponent
  • Temporal long-term dependence

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